I. Background

The work of the Accord Implementation Group's Operational Risk Subgroup (AIGOR) focuses on the practical challenges associated with the development, implementation and maintenance of an operational risk management framework meeting the requirements of Basel II 1 , particularly as they relate to the Advanced Measurement Approaches (AMA). The AIGOR has been specifically mandated to, among other things, exchange and catalogue subgroup members' views on operational risk implementation issues and the range of acceptable bank practices for measuring and managing operational risk under the AMA.

In recognition of the evolutionary nature of operational risk management as a risk management discipline, the Basel II Framework intentionally provides a significant degree of flexibility for banks in the development of an operational risk management framework under the AMA. It is not surprising, therefore, that the range of practice that has emerged in relation to any given issue tends to be quite broad.

The flexibility provided banks in the development of an AMA, however, should not be interpreted to suggest a lesser standard of supervisory review and assessment or that supervisors are prepared to accept as reasonable any and all responses to the challenges banks face in this area. On the contrary, prudential supervisors have an interest in identifying and encouraging bank operational risk practices that are consistent with safety and soundness and level playing field objectives. Furthermore, at various times the industry has encouraged the AIG and its subgroups to establish and maintain high standards for what constitutes acceptable practice and to publish "sound practice" papers to communicate those standards and promote consistency across jurisdictions.

II. Purpose

Against this backdrop, the AIGOR has prepared a "range of practice" paper using information obtained from members' supervisory work, benchmarking exercises, discussions with bank management and other sources. This paper describes specific practices that have been observed in relation to some of the key challenges AMA banks 2 currently are facing in their operational risk-related work in three subject areas: internal governance, data and modelling. 3

While this paper does not address all issues or reference every practice identified with respect to any given issue, it does focus on the key issues in each of the three subject areas and provide a reasonable cross-section of the practices observed with respect to those issues. Because it is focused on bank, and not supervisory, practice, the paper does not address home-host issues.

No judgment is intended or implied regarding the acceptability of any of the practices reflected in this paper. For example, the fact that a particular practice is discussed should not be interpreted as an endorsement of that practice by the AIGOR or any of its members. Nor should the absence of a particular practice be interpreted to imply either that it is or is not considered acceptable by supervisors. The principal purpose of the paper is to catalogue the key issues and corresponding practices observed among AMA banks operating in AIGOR member countries. As such, the paper provides the international community of bank supervisors a means of framing the discussion of acceptable practice in both the management and measurement of operational risk and monitoring the evolution of industry practice and supervisors' reactions. It is also expected to be a valuable resource for both banks and national supervisors to use in their respective implementation processes.

In light of its broad membership and exposure to AMA banks, the AIGOR is an ideal forum in which the supervisory community might develop a perspective on the acceptable range of practice. In so doing, the AIGOR can facilitate greater consistency in the assessment of AMA practices among national supervisors. While the paper does not purport to define best practice, it is reasonable to expect that some of the practices identified in the development of this paper might be viewed as falling outside the range of what supervisors consider acceptable. Where observed practices are determined to be unacceptable, the AIGOR anticipates that it will identify them as such, as and when a clear consensus emerges, contributing to a narrowing of the range of practice over time. It is reasonable to expect that when a particular practice is identified as being unacceptable, national supervisors will give due consideration to the need for appropriate transitional arrangements.

This paper does not constitute new rules or revisions to the Basel II Framework. The AIGOR may update this paper from time to time as new issues are identified, industry practices evolve and supervisory experience grows.

III. Introduction

The challenges and corresponding practices identified to date have been grouped in this paper under the following subject areas: internal governance issues, data issues and modelling/quantification issues. Each subject area and the individual issues covered under them are defined. Relevant references to the Basel II Framework are included, along with a brief discussion of the significance of and challenges raised by individual issues. Finally, the observed practices are described.

2 "AMA bank" refers to a bank that is targeting the AMA approach in its implementation of Basel II.

3 Some of the challenges and corresponding practices covered in this paper may also be relevant to banks implementing the Standardized Approach (TSA) and, to a lesser extent, the Basic Indicator Approach (BIA). Guidance from the Basel Committee for TSA and BIA banks includes the relevant sections of Basel II and Sound Practices for the Management and Supervision of Operational Risk (February 2003), which is also applicable to AMA banks.